In May 2024, the FCA began a staged process of implementing its new anti-greenwashing regulations. A key part of this has been the introduction of four labels to describe types of sustainable investments (the labels are ‘sustainable focus’, ‘sustainable improvers’, ‘sustainable impact’ and ‘sustainability mixed goals’).
In order to use the labels, funds and portfolio managers need to have demonstrated analysis of the underlying investments within their portfolio, demonstrating that they meet or have the potential to meet a robust, evidence-based standard of sustainability. The intent of the new labels is to increase transparency in sustainable investment market.
Sight of these new of labels should bring comfort to investors that their ESG wishes are being met. However, good intentions have still left some confusion among buyers and the regulation has created an important difference between their implementation in a model portfolio as opposed to a fund.
See also: FCA releases proposals to expand SDR to wealth managers
Impact on costs and returns for everyone
While the overall impact is positive and should help to increase trust in the overall sustainable investing class, the unintentional consequence for both fund and portfolio managers is a significant level of increased cost. The costs to firms of implementing the labels include one-off and ongoing compliance costs, with the FCA estimating a total cost of £92.3m and annual ongoing cost of £52.7m to the industry.
The first challenge for managers in implementing the rules is the dilemma of whether to pass at least some of this additional cost through to investors. While understandable and tempting to do this, if costs become higher for sustainable portfolios then this will very likely inadvertently limit demand; and worse, the rate of return could suddenly look materially worse than ‘traditional’ portfolios.
Portfolio managers face other dilemmas
Many investors will think of a model portfolio in the same way they think of a fund; a multi-manager or fund-of-funds does the same sort of thing so extending the rules to portfolio managers makes sense. However, because of the more flexible nature of the investing universe in a model portfolio, there are some additional challenges in implementation for DFMs.
To meet these, access to and availability of reliable data will be essential for portfolio managers as they develop and adhere to the ‘robust’ and ‘evidence-based’ standards defined by their sustainability methodology.
Some will take up the option to utilise a third-party for this; but portfolio managers will need to balance outsourcing this service with their oversight requirements. The FCA has an expectation that many portfolio managers will already have robust asset selection methodologies that can be extended to incorporate sustainability metrics, but some may not, and these will face much bigger challenges than others.
Consumer disclosure issues
Portfolio managers will also have to be aware that using the new labels adds another type of disclosure to consumers; potentially one that will be scrutinised more, given the level of focus on the topic of sustainability. The choice of a sustainable portfolio is likely to be an active consumer choice, one that motivates the buyer to look through criteria more actively than might be the case for a ‘traditional’ portfolio.
Further, where a model is available on a platform, the platform’s investment committee now also has obligations under the FCA’s new anti-greenwashing rules. However, this is a manageable obligation. Although the rules extend the data and disclosures that they need to make visible to customers about underlying assets; they should not materially change how the platform relates to its clients and how it works.
More work
Overall, DFMs who want to use the sustainable labels will have to become comfortable with an unavoidable extra workload on reporting. They cannot rely on fund providers, and they will have a duty of care to look through the funds to selection of underlying assets much more carefully.
Portfolio managers will have to use full look-through to assess their whole portfolio and ensure that the 70% threshold for sustainable assets is met on an annual basis. How close a portfolio manager will sail to the 70% threshold will need to be considered against portfolio drift and rebalancing frequency.
The new rules mean that they cannot simply rely on other’s labels although they can use these as an initial filter to help with their own assessment. While the methodology used can be determined by the portfolio manager, there are specific criteria on what each label objectives are, so these also need to be factored into the planning process.
It all adds up to more work and more cost; albeit for a cause that is important to consumers, and a class of investments that is in need of greater transparency and an enhanced regime to prevent greenwashing.
